Elevate Your Investment Strategy with Advanced Stock Selection

The Sharpe Ratio is named after William Sharpe, Nobel winner in 1990 along with Harry Markowitz, who developed the mean-variance portfolio approach. They were among the fathers of what we call Modern Portfolio Theory.  The Sharpe ratio is the expected return over the expected risk, and the higher the better. It is a very useful tool for stock selection. A Sharpe Ratio of 1.0 suggests that the expected return of say 10% has a volatility of 10%.  Many stocks will have Sharp Ratios below 1.0 and some well above, but we need to be careful about any estimates above 2 or 3 as these may be unrealistic. Still, you can select filters that include such stocks or those with even higher ratios.  This is a very useful stock selection filter.

Sharpe Ratios do not consider diversification or how stocks fit together, that is where Markowitz comes in.  Sharpe Ratios are higher for individual stocks than they are for aggregate portfolios as a result of some stocks moving counter to one another.  Stocks with low or negative correlations can provide much more stable portfolios.  Note that we do not use historical correlations for most stocks but rather forecast correlations since we know that the correlations vary over economic cycles.  We do use historical assumptions for the micro stocks that have limited or no options markets.   Using only historical correlations will result in a fairly random portfolio results and while diversification helps, we think we can do better with forward looking models. Be very careful about picking any stock or portfolio where implied volatilities are over 35%. These are very risky.

Now, let’s say you picked out several stocks with very high Sharpe Ratios, and the expected results look great. One problem may be that you picked out only micro stocks with little liquidity or thin trading. By definition, small-cap stocks are those with total aggregate market valuations or market capitalization under $2 billion. From $2B to $10B, we call these mid-sized market cap stocks, and $10B plus are large-cap stocks. Many investors will not invest in any company with a market cap under $1B because they are concerned about the ability to buy or sell without affecting the stock price. Buying several million of Microsoft will not affect the price, but for a market cap stock at $50 million (of which there are many) and an average trading volume of a few hundred thousand dollars, buying or selling a large order could affect the price.

If you are a small-scale investor, market cap may not be a big concern, but also keep in mind that small companies may have more insider ownership, so be sure to research that. You generally don’t want to buy stock in a company worth $30 million where one investor holds $20 million of the total share value. If you stick with larger firms, this is generally not an issue.

Investors seeking more current income from their portfolio always have the option to sell off shares. This strategy may also reduce tax consequences, as the max capital gains rate is well below the max rate on dividend income. However, for investors who want steady income, setting a minimum filter on dividend rates is a good criterion to consider.

Stocks with higher dividend rates, like utility companies and REITs, generally do not have high expected growth rates in terms of their stock prices. Stocks with low or no dividend payouts may be higher-income growth stocks.

Also, be aware that very high dividend rates, such as 10% or above, are generally not sustainable. They may reflect the expectation that dividends will be cut or signal other problems with the company's earnings, so be cautious when chasing very high dividends. Still, they may fit well into a 401(k) plan, an IRA account, or a child’s education fund where current earnings are not taxed.

The average PE ratio in the stock market is typically about 15 to 20. A PE ratio of 20 suggests investors are willing to pay twenty times the current earnings of the firm. Average PE ratios tend to move inversely with general interest rates — when treasury rates are relatively low, we tend to see higher PE ratios, and vice versa. A high-growth stock might have a PE ratio above 30, 50, or more. Buying a stock at 50 times its current earnings means you expect significant growth, often driven by new products like revolutionary drugs, cutting-edge watches, TVs, smartphones, or exercise apps. High PE ratio stocks tend to be much more sensitive to changes in earnings compared to low PE stocks, so missing an earnings forecast can dramatically affect the price. Stocks with below-average PE ratios are called value stocks, while those with above-average PE ratios are called growth stocks. Generally, a portfolio with below-average PE ratios is considered less volatile and more conservative than one composed solely of above-average PE ratio stocks.

High-growth stocks with high potential returns also have high volatility. We use forward-looking implied volatilities extracted from the options market rather than historical volatility measures. When no options are available to assess volatility, we default to the industry group’s average volatility. There are over 100 industry subgroups. You may want to lower the risk of a portfolio by screening out stocks with very high volatilities, but keep in mind that this will also dampen your potential upside returns.

For those looking to spot stocks trending above previous ranges, we calculate the 200-day moving average and allow you to choose whether to find stocks breaking out of old trading ranges. This serves as a technical indicator of stock market trends since we don’t necessarily know why a stock has moved beyond prior trading ranges. Perhaps others know something we don’t, and it may be worth conducting further research.

A stock market index refers to an exchange or a group of stocks, such as the Dow Jones 30 or the S&P 500. Exchange-traded funds (ETFs) generally combine a group of stocks based on industry, market capitalization, or other criteria. They function similarly to mutual funds but are typically more passive and have lower management fees. If you like a particular industry but dislike certain stocks within an ETF, you can pick a subset of stocks and sort them by Sharpe Ratio, investing only in the top half. This approach allows you to gain the diversification benefits of an ETF while aiming for higher-than-average returns or lower-than-average risks. Why invest in all 50 energy stocks when 20% are expected to remain flat or decline in price? Why not select the best 20? Simply choose the ETF and then sort by stock Sharpe Ratios. You’ll typically notice some stocks are expected to decline in price.